Never Trust an Investor With a Microscope

By William Patalon III
And Jason Simpkins

Anytime stocks are on a record run, and you sense that investors are searching a little too hard for the good news needed to keep the advance alive, it’s probably a good time to start being a little cautious.

But when you see those investors start using microscopes to search for good news, it’s probably time to head for the exits and perhaps even for the bunker.

When it comes to U.S. stocks, that time to hunker in the bunker may come upon us sooner than you think.

Perhaps even this week.

In recent months, as U.S. stock prices soared and set one record after another, it seems as if U.S. investors are having to squint harder and harder to keep that necessary “good news” in sight.
Long-term, the U.S. market is a fine place to invest. But the real growth is taking place abroad. The high risk inherent in U.S. stocks and the greater gains available abroad right now underscores yet again just why we are such big proponents of international investing.

Yesterday, investors trained their rose-lensed microscopes on some moderately upbeat inflation news that was tucked inside a decidedly mixed inflation report and sent the Dow Jones Industrial Average up over the 14,000 level for its first time ever. And while the blue-chip index failed to stay above that threshold, it still managed to post its fifth-straight gain and fourth-consecutive record close.

The Labor Department’s Producer Price Index report said that prices at the wholesale level fell 0.2% in June, the first decline since a 0.6% drop in January. Economists had forecasted a 0.2% increase in the prices of goods at the wholesale level.

However, the so-called “core” inflation figure, which excludes the usually volatile food and energy prices, heated up and rose a greater-than-expected 0.3%, reflecting a jump in automobile prices. Passenger-car prices rose 1.4%, the biggest increase since November, and light trucks posted a 1.0% increase. Excluding the effect of higher car prices, core prices only rose 0.1%.

Investors dismissed the increases, given their cause, but may not have that luxury with the rest of this week’s scheduled reports.

The PPI is one of three inflation measures the government reports. Prices of goods imported to the U.S. rose 1% in June by virtue of higher costs for oil and industrial supplies, according to a report issued by the Labor Department July 13.

The Consumer Price Index, a more closely watched barometer of inflation, will be released today. And Federal Reserve Chairman Ben Bernanke is scheduled to testify before both houses of Congress this week to deliver the U.S. central bank’s midyear economic forecast.

He’ll speak to the House Financial Services Committee starting at 10 a.m. today, where he is widely expected to acknowledge to the improvement in core inflation readings, while emphasizing that additional improvement is imperative. He’ll appear before the powerful Senate Banking Committee tomorrow.

Investors will be following Bernanke’s comments closely, looking for hints about the central bank’s views about inflation. Price increases in commodities, energy and other key economic areas have caused considerable investor angst in recent months, although these higher prices have yet to blunt all-important consumer spending – or short-circuit the rally in U.S. stocks.

Another potential pothole: Amid a flurry of other news and reports scheduled for release throughout this week, 11 of the 30 Dow companies report their quarterly financial results. If any of these economic reports or earnings announcements disappoint investors, the share-price declines recorded that day are likely going to be just the first in a string of downbeat trading days.

Here’s why.

The Dow punched through the 14,000 level in the first half hour of trading yesterday, and soared to nearly 14,022 – just 57 days after it traversed the 13,000 level. But the fuel hasn’t been the great earnings reports and flawless economic news: It’s been the greed-induced euphoria of a relentless buyout binge, where private-equity funds and acquisitive corporations have enabled investors to repeatedly swap the shares in one company or another for cold-hard cash – with the takeover premiums acting as unexpected bonuses.

And that’s enabled U.S. consumers to keep spending, despite only modest income growth, a non-existent savings rate, and steadily rising gasoline and energy prices – all of which have taken a bite out of consumers’ cash.

And that doesn’t include the housing market, whose decline has far exceeded what was generally believed to be a “slump.” For several years, as housing sales soared causing prices to skyrocket, consumers used them as bottomless “ATMs,” using home-equity lines or cash from sales as an addendum to their job wages, causing a surge in spending and in stock-market investing that was well above any conceivable norm.

The downdraft has been just as breathtaking, and won’t end anytime soon. Just yesterday, as the Dow hit another record, a key measure of industry sentiment on the U.S. market for new homes fell to its lowest point in more than 16 years, as builders wrestle with a rising tide of unsold houses during a period of falling prices all across the country.

The National Association of Home Builders/Wells Fargo Housing Market Index – an assessment of homebuilder perceptions of market conditions for the next six months – fell to a reading of 24. That was below the consensus expectation of 27, was the lowest reading since January 1991, and is obviously nowhere near the rating north of 50 that’s needed to indicate positive market sentiment. The index has been below 50 since May 2006, the NAHB reported yesterday.

And it’s not just the lousy sales and falling prices that have transformed the once-cheery U.S. housing market into something better labeled as “The Creeping Terror.” Reckless handouts of “subprime” mortgages are resulting in an acceleration of defaults that are spreading throughout the U.S. financial system like the “Black Death” spread through Middle Ages Europe.

But that bad news, too, has so far failed to seriously undermine stock-market investor confidence, despite the revelations that continue to emerge and grow in both size and scope.

The Wall Street Journal reports in its online edition today that investors in the two now-infamous Bear Stearns Cos. (NYSE: BSC) hedge funds that made big bets on subprime mortgages have been practically wiped out. In a letter circulated by the investment bank [to see the actual letter, click here] , and according to information inside sources provided the Journal, Bear Stearns said one of its funds was worthless, while the second was worth one-tenth of its value from just a few months ago after the subprime-related trades it made went sour. The company, heralded as a leader in fixed-income investment banking, has already had to inject $1.6 billion in rescue funding, an amount that still may need to be augmented.

Clearly, companies that incurred these losses – and others – will soon start making public disclosures of their losses, especially as quarterly financial reports are released. The impact on stock prices could be devastating, another potential source of the sell-off we mentioned above.

Bear Stearns shares, for instance, were down nearly 20% from their 52-week highs. But with yesterday’s revelations, the stock dropped another 3.6% in after-hours trading.

Think about how you’d feel if a broad swath of U.S. shares shed nearly a quarter of their market value, once the microscope-wielding Pollyanna investors ran out of good news at which to squint.

You’d be into your online brokerage account issuing sell orders and into your bunker before you could say “subprime lending.”

And that’s even before we factor in the impact of rising oil prices, yet one more problem that could bring about the bull-market’s demise.

In an interesting bit of parallel irony, as the Dow crossed the 14,000 level and then fell back, crude oil crossed the $75 a barrel level on the New York Mercantile Exchange, but also failed to hold its gains. The one difference: While the Dow still set a record even with its afternoon retrenchment, the crude-oil surge fell short of its record high.

Another interesting parallel: The Dow has jumped 12% so far this year, while crude oil is up nearly 50% from its January nadir. And in both cases, upbeat investors appear unwilling to acknowledge the less-than-upbeat back-story. Stocks have risen in spite of weakening corporate profits, the lousy housing market and rising interest rates, and investors seem to expect that the bull market will continue. Those same investors are betting on stocks because they believe inflation will remain in check, which would require oil prices to remain stable, if not decline. But that expectation doesn’t factor in the very real concern that tight supplies and continued high demand is more likely to send oil prices much higher before any reversal is possible.
If all these aren’t enough to send you into the bear-market bunker, perhaps this one last prediction will fill the bill: The credit market is going to take it on the chin as “easy money” disappears.

And, as we stated at the outset, that easy money is a central element of the buyout boom – the buyout boom that’s allowing investors to ignore all the other financial and economic problems that should have short-circuited the U.S. bull market some time ago. The hundreds of billions of dollars in buyout deals that have buoyed stock prices will also now exit stage right.

Consumers, too, will feel the pain of tough credit. And high-risk homeowners who signed up for low  “teaser” rates on adjustable-rate mortgage (ARM) loans may well get hammered when those loans re-set at much higher rates in the months to come. But the borrowers won’t be able to refinance them at lower rates, as had been the plan all along. The money just won’t be available.

Said the folks at Standard & Poor’s Leveraged Commentary & Data:  “There is no denying it. It is ugly out there,” wrote the influential credit-market watchers at Standard & Poor’s Leveraged Commentary & Data.

Perhaps it’s time to make sure you’re well prepared. And that your bunker is ready for occupancy.

But most important of all, take a good look at the international markets for some of your investing opportunities.